Any serious rift may force the center-right Conservatives to agree to stricter reform or face the outside possibility of an embarrassing defeat in parliament when any proposed legislation goes to the vote.
The publication of the Independent Commission on Banking’s final report next Monday will kick off the political wrangling, with the government expected to come up with proposals for legislation by the end of the year.
Both parties will want to avoid the tag of being too soft, with public resentment still lingering over the role of the banks in the 2008-9 financial crisis, although the technical nature of any reforms will make it easier to fudge a response.
And the Conservatives, who favor light-touch regulation and have close links to the financial sector, may be prepared to take a short-term hit in popularity if it keeps the City of London — and the party faithful — on side.
“They are neo-liberals,” said Steven Fielding, a political history professor at the University of Nottingham.
“They probably genuinely feel that, apart from a little bit of tweaking, there really isn’t anything much that needs to be done. Maybe they will take a short-term hit because they won’t be seen to be banker bashing but in the longer term, so long as it all works out and the economy grows, most people won’t remember.”
Some analysts say fears over the health of the British economy, which is struggling to rebalance and grow after an 18-month recession, have weakened the case for coming down too hard on a sector that was a powerhouse of growth before the 2008-9 financial crisis.
The government has backed the ICB’s interim recommendations on ringfencing retail and investment operations at banks, but it has since said it will look closely at the ICB’s final proposals, rather than run with them, leading to speculation that a watered-down solution is on the cards.
That has set the stage for another round of infighting between the two coalition parties. Battles that, up until now, have been largely lost by the Lib Dems.
“If (Lib Dem leader) Nick Clegg decides it would be popular with the electorate to be seen to punish the banks, the party would be more inclined to vote as one, so the government would have to offer concessions or face defeat,” said Simon Lee, a senior politics lecturer at the University of Hull.
So far on controversial areas of policy, such as higher university tuition fees, Lib Dem ministers and allies have voted with the Conservatives, while Lib Dem backbenchers have voted against.
Analysts argue that banking reform offers a golden opportunity for the Lib Dems to regain some trust from voters who feel betrayed by a party that has backtracked on several of the policy promises it made in opposition.
Business Secretary Vince Cable, a Lib Dem, has long argued for a hard line to be taken with the banks and has accused them of using the eurozone crisis to stave off reform.
“If the Lib Dems are going to restore their reputation with the electorate now, they’ve got to be seen to be much fiercer critics of the government,” Hull’s Lee said.
Clegg, the son of a banker, reiterated his desire to see fundamental change in the financial sector at an event in London on Monday.
“There has to be structural reform in the banking system, so that the banking system can never again indulge in reckless and irresponsible lending practices and then hold a gun to the head of the rest of the British economy,” he said.
“Our will to see through structural reform is absolutely unambiguous and clear.”
However, Treasury officials stress that the ICB’s report will form just part of a wider approach to reforming Britain’s financial system, alongside making the Bank of England more responsible for financial stability.
Insiders say the government will aim to strike a balance between tougher regulation and ringfencing operations in a way that doesn’t cripple profitability and safeguards a sector that is crucial for growth.
The road ahead is a precarious one for the politicians.
Some banks have already hinted they might relocate away from London if Britain’s tax and regulatory regime becomes too hostile. Conservative Prime Minister David Cameron and his finance minister George Osborne have said protecting London’s position as a global financial center is a top priority.
“The bottom line reality is that politicians know the City of London is hugely influential, they are very sensitive to that industry’s needs and what the industry says it needs,” Nottingham’s Fielding said.
“It would be a brave politician who would take them on because the dangers are very apparent.”
